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1 Introduction Overview One Size Does Not Fit All Variable annuities are not a one-sizefits-all investment. Variable annuities are products that have gained great popularity because of retirement planning. Some of the best variable annuities have performed quite well over time and have produced excellent returns. They are a hybrid of insurance and investment products. The individual who sells them must be licensed to sell both securities and life insurance. The customer also must have a grasp of the complexities of the product.

2 Popular Variable annuities have become quite popular in the marketplace because the insurance nature of the product can guarantee an annuitant a lifetime income. The securities element of the product primarily mutual fund-type investments offers the contract holder the potential for growth that may keep pace with (or exceed) inflationary trends. In addition, during the growth or accumulation phase, growth inside the annuity s separate account takes place on a tax-deferred basis. Also, if the contract holder, known as the annuitant, dies during the accumulation phase, the contract will provide a death benefit for the named beneficiary. All of these factors make these products quite popular for seniors and individuals who are seeking devices to fund or supplement their retirement income. Individuals who are attracted to the basic positive aspects of these contracts should recognize that they also contain several specific drawbacks for investors. As previously mentioned, these products have elements of life insurance policies and securities. Because they are variable, the contract holder while hoping for a hedge against inflation bears investment risk in the marketplace. There are also a number of costs that the investor must bear. Variable Annuity Phases There are two distinct phases to a variable annuity: the contribution or accumulation phase, in which the investor is making premium deposits, and the annuity or distribution phase, in which the annuitant is receiving monthly payments from the annuity company. An annuity may be purchased in one of two ways: with a series of payments often called a periodic payment annuity or with a single/lump-sum payment (premium). With an immediate annuity, the client begins receiving periodic payments, generally within 30 days, and there is no accumulation phase. In ths case, the client has directly purchased annuity units. If the contract is a deferred annuity, it may be purchased as either a periodic payment annuity usually through a stream of deposits or as a single premium (payment) deferred annuity. In this instance, the client purchases accumulation units. Please reference the online course to view this activity.

3 The deposits into a client s variable annuity go the insurance/annuity company s separate account, which is invested in subaccounts that are normally chosen by the client to meet his objectives. The separate account is registered with the Securities and Exchange Commission as an investment company. The client bears all the risks for the performance of the separate account, and there are no guarantees for earnings within this account. Deposits into the account are made with after-tax or cost basis money. If the annuity is a deferred annuity, the earnings from the instruments held in the annuity s separate account grow tax deferred until the client takes distributions. The client will not unlike a direct investment in mutual funds have a choice of whether to take distributions in cash or additional shares. All distributions from instruments held in the separate account must be reinvested, causing the value of the accumulation units to grow. This, of course, produces a compounding effect on the growth of the account. The assets in the investor s separate account continue to grow tax deferred until the investor chooses to take distributions. Withdrawal Options Once an investor decides to begin withdrawals, there are decisions to be made that have serious consequences. Please reference the online course to view this activity. Fees and Expenses There are various fees and expenses that are costs to the investor, charged in addition to sales and surrender charges. Examples are given in the following. Please reference the online course to view this activity. Annuity Riders

4 Followingare some of the many annuity riders. Please reference the online course to view this activity. Regulatory Issues with Variable Annuity Transactions Rule 2330 For the past several years, FINRA and the SEC have been studying sales and supervision practices of various broker/dealers and registered representatives in the sale of variable annuities. Long Time Coming FINRA Rule 2330 did not spring up unexpectedly or without considerable background rationale. The findings of a joint staff report on broker/dealer sales of these products highlighted a number of weak practices. One of the specific areas the report addressed were failures by the broker/dealer and the supervisors to provide adequate, firm guidelines for suitability to registered representatives and to actually oversee and examine the practices of those involved in selling the products to public customers. The report indicated that there was a pattern of repeated problems that began with firms' failure to provide adequate written guidance, the failure of supervisors to monitor the activities of those selling variable annuities, the failure of supervisors to enforce the rules of the firm and FINRA governing suitability, and the failure of registered representatives to observe the basic rules of suitability and ethics required in the securities industry. Specific failures by firms were documented as: the lack of written supervisory procedures to specifically address the firm s variable product business; inadequate procedures for addressing customers' written communications as complaints when warranted; no specific, written requirement to determine customer objectives; no requirement for the registered representative to determine suitability of variable annuity products for specific clients; and firms records often did not include the most fundamental information about clients, such as income, net worth, and investment objectives. The report pointed out a number of repetitive failures by supervisors themselves, including: failure to review and approve transactions in variable products; failure to investigate red flags in transactions by registered representatives

5 that involved excessive switching of annuities; and failure to place registered representatives on heightened supervision when abusive practices were detected. In many cases, the most elementary evidence of supervisory oversight, such as a principal s signature on new account forms, order tickets, and other documents, was missing. Recent Enforcement Involving Firms, Supervisors, and Registered Representatives The previous examples are by no means a comprehensive list of the findings of the joint staff report, but they serve to indicate the severity of the problems discovered by the examination of firms, supervisors, and representatives. In recent cases where enforcement resulted in sanctions imposed on firms or individuals, the failures noted previously are clearly illustrated. Please reference the online course to view this activity. Requirements of FINRA Rule 2330 In light of these few examples of institutional neglect, failure to supervise, and egregious unethical behavior, FINRA s Rule 2330 evolved. After several years in the making and following the lead of earlier NASD efforts, the rule, which is only applicable to deferred annuities and not immediate, was approved by the SEC. Rule 2330 imposes requirements in four main areas: Registered representative requirements for recommended transactions Principal review and approval obligations for all transactions Firm supervisory procedures Firm training program We will examine each of these requirements individually regarding the rule and FINRA s guidance.

6 Registered Representative Requirements for Recommended Transactions Because the registered representative is the first point of contact with a customer and is the party who possesses the greatest personal knowledge about the situation, Rule 2330 imposes a number of specific requirements for ascertaining the suitability of variable annuity recommendations. The rule requires that registered representatives must have a reasonable basis to believe that the customer has been informed, in general terms, of the material features of a deferred variable annuity and requires that the representative also make a reasonable effort to obtain and consider various types of customer-specific information. Specific guidance from FINRA lists these requirements as follows. Please reference the online course to view this activity. Registered Representative Requirements for Recommended Transactions (cont.) FINRA s guidance for registered representatives requires the registered representative to have a reasonable basis to believe that the customer has been informed of the material features of a deferred variable annuity, such as Please reference the online course to view this activity.

7 Registered Representative Requirements for Recommended Transactions (cont.) Under Rule 2330, a registered representative also must have a reasonable basis to believe that the customer would benefit from certain features of deferred annuities, such as Tax-deferred growth The tax-deferred growth feature normally a large selling point for the registered representative is not a universal solution. This feature is overshadowed if the annuity is within an IRA, for instance. Annuities have a number of extra charges, so they also would be more expensive as a funding vehicle. The feature also may be less than optimal for those in lower tax brackets. Annuitization In most cases, when a client annuitizes his account, virtually all control of the account is lost, and the client is locked into a series of payments for life. A registered representative has a special obligation to understand and carefully explain the annuity payout options to customers. It is reported that only 1% of all annuities are annuitized. Two reasons for this are that many annuity owners are under age 59½ and individuals purchase annuities for deferred growth rather than for lifetime income. Death benefits In some annuity payout options, there are no provisions for a death benefit once the contract is annuitized. As noted previously, the death benefit payable to a beneficiary during the accumulation or growth phase is limited and subject to negative tax consequences for the beneficiary compared to life insurance products. Under the provisions of FINRA Rule 2330, the registered representative must make a suitability determination as to the investment in the deferred variable annuity at the time of purchase or exchange. This includes careful evaluation of the following by the registered representative. Investments in the underlying subaccounts The investments themselves must be treated with the same scrutiny for suitability as any other securities recommendations for clients. Age, financial status, attitude, and investor sophistication are primary touchstones to test a recommendation for its suitability for a specific client. All riders and other product enhancements A clear, in-depth understanding of variable annuities and the companyspecific products to be recommended to a customer is vital to registered representatives. As noted previously, in one

8 enforcement action by FINRA, a registered representative sold riders at an additional cost, of course to clients who were not eligible to use the rider because of age. Registered Representative Requirements for Recommended Transactions (cont.) Registered representatives must, under the rule, have a reasonable basis to believe that a recommended deferred annuity exchange transaction is suitable for the particular customer, considering, among other factors Whether the customer would incur a surrender charge or be subject to a new surrender charge: as already noted, surrender charges commonly last for as many as seven years. Among the first factors that a registered representative should consider when determining whether an exchange should be recommended is whether an exchange will be costly to the customer. If the exchange would incur surrender charges, would the new annuity subject the client to yet another series of years with surrender charges? Whether the client would lose existing benefits or be subject to increased fees or charges: in all cases involving exchanges, the registered representative must consider the benefits already purchased by the client. The question of increased fees resulting from, among other things, new sales charges, administrative costs, and management fees must be carefully considered with full disclosure in close consultation with the customer before an exchange may be considered. Whether the client has had another annuity exchange in the past 36 months: if so, the client s costs for the exchange have probably not yet been recovered. Numerous exchanges in relatively short periods are akin to churning a client s account. As a unique item, Rule 2330 establishes a documentation requirement for the registered representative: Finally, a registered representative who recommends the purchase or exchange of a deferred variable annuity must document and sign the determinations discussed above. This signed document must provide reviewing principals with enough information to adequately assess whether the registered representative has complied with the requirements of Rule This requirement usually does not exist for other securities sales.

9 Principal Review and Approval Obligations for All Transactions The new rule has added another unique requirement: with regard to timing, the rule requires review and approval prior to transmitting a customer s application for a deferred variable annuity to the issuing insurance company for processing, but no later than seven business days after the date when a firm s office of supervisory jurisdiction (OSJ) receives a complete and correct application package." First, the concept of a principal s approval being required before the execution of a securities transaction is unprecedented. The timing issue required special FINRA and SEC exemptive relief, specifically to permit principal review under Rule 2330, from the prompt transmittal and net capital requirements of Exchange Act Rules 15c3-1 and 15c The request for relief from these requirements was originally submitted by NASD before the consolidation with the NYSE Regulation Authority and the creation of FINRA. In the regulatory notice dated January 2010, FINRA reminded firms of their responsibilities under Rule 2330 and spoke to the ability of firms to hold customers' checks against the need to have a principal approve the transaction. In that notice, FINRA clarified that the interpretive relief applies only if seven conditions are present. The reason that the firm is holding the application and/or a customer s check payable to a third party is to allow completion of principal review of the transaction pursuant to FINRA Rule A principal makes a determination of whether to approve or reject the purchase or exchange in accordance with the provisions of FINRA Rule The associated person who recommended the purchase or exchange makes reasonable efforts to safeguard the check and to promptly prepare and forward a complete and correct copy of the application package to an OSJ. The firm ensures that the check is safeguarded and that reasonable efforts are made to forward the application package to an OSJ. The firm holds the application and/or check no longer than seven business days from the date an OSJ receives the application package. The firm maintains a copy of each such check and creates a record of the date the check was received from the customer and the date the check was transmitted to the insurance company or returned to the customer. The firm creates a record of the date when the OSJ receives a complete and correct copy of the application package. If these seven conditions are not present, FINRA s interpretive relief will not apply, and it will enforce FINRA rules as appropriate.

10 Principal Review and Approval Obligations for All Transactions (cont.) Without this exemption, smaller broker/dealers would have been subject to higher net capital requirements, and if they did not promptly transmit customers' checks to the insurance company, they could have been found to be in violation of the rule. Also, without these exemptions, compliance with the rule would have shortened the time in which the principal would be able to review the transactions. Regarding the approach that the principal must take in evaluating a proposed transaction, he or she must view the issue at hand on the basis of all the factors that a registered representative must consider when making a recommendation to a customer. The principal must consider all transactions as if they had been recommended for purposes of his or her review. Principal Review and Approval Obligations for All Transactions (cont.) If the principal does not approve the transaction, the principal still may authorize its processing if (1) It was not recommended and (2) the customer, after being told why the principal found it to be unsuitable, still wants to proceed with the purchase or exchange. Although not a part of the rule, the SEC release approving the rule adds a footnote that appears to indicate that it expects broker/dealers to assess the mental competence of customers before approving variable annuity transactions. The footnote states the following: The general suitability obligation requires a broker-dealer to consider its customer s ability to understand the security being recommended, including changes in the customer s ability to understand, monitor, and make further decisions regarding securities over time. This comment possibly was directed toward the protection of seniors from predatory sales practices that tend to take advantage of older people.

11 Firm Supervisory Procedures FINRA s guidance addresses this element of Rule 2330, stating that the rule requires broker-dealers to establish and maintain written supervisory procedures. As mentioned earlier, the joint SEC/FINRA report detailed repeated examples of failures by broker/dealers to have written supervisory procedures in place. In several instances, the report details the lack of the most rudimentary customer information that would be necessary for (1) the registered representative to make a suitable recommendation and (2) the principal to intelligently review and approve or disapprove the proposed application for a variable annuity. The rule requires that broker/dealers establish surveillance programs to detect patterns that may indicate unsuitable transactions such as inappropriate or excessive exchanges. The requirement places an obligation on firms to put in place programs that would indicate the need for further review of the transactions themselves or the registered representative submitting the applications for potential misconduct. Appropriate corrective measures to be undertaken by the firm are required by the rule. FINRA s rule does not preclude the use of automated supervisory systems and states that a combination of automated and manual systems for supervision is also acceptable. The rule does, however, stress that the principal s responsibility is not diminished by the use of automated systems and states that a principal is obligated to ensure that the system is adequate for the purposes of supervision as required by the rule. The guidance also holds the principal responsible for any deficiency in the system s criteria that would result in the system not being reasonably designed to comply with Rule Ultimate Responsibility A principal may use computer systems as a tool for supervision and surveillance, but ultimately the principal is responsible. Firm Training Program The rule requires that broker/dealers establish training programs on variable annuities for both registered representatives who sell these products and for principals who review the transactions. For some time, regulators have shown concern that registered representatives who sell these products do not have a clear understanding of their complexities and are, therefore, unable to adequately assess the suitability of the products for their clients. Although variable annuity contracts share many common features, there are add-ons and riders that make the contracts unique to the issuing company. Both registered representatives and principals must have a thorough understanding of Rule 2330, variable annuities in general, and the specific

12 characteristics of the products and riders they are recommending and reviewing. Firm Training Program (cont.) The requirement for these training programs is meant to address weaknesses in the system such as those identified in the SEC/FINRA joint report, which found that: training programs of broker/dealers often did not address the sale or supervision of variable annuities; firms provided only general training to registered representatives and did not cover special features of the annuities or specific suitability issues; principals reviewing variable annuity transactions were often not sufficiently trained or experienced to recognize abusive sales practices; and the annual compliance meetings and firm element continuing education programs did not include information on the sale and supervision of variable annuity products. Broker/dealers involved in the sale of variable annuities must now ensure that their training programs address these weaknesses. Best Practices for Supervisors of Variable Annuity Transactions New Accounts Potentially useful checklists for a supervisor s review of variable annuity transactions would have differing elements for new accounts and for exchanges. Information-gathering by the representative: Did the registered representative gather and record client information that would include the following? Age and marital status of the customer Sex Investment objective(s) defined by the client Time horizon for investment Attitude toward risk Need for liquidity

13 Understanding of market risk Premium allocation among subaccounts Financial and tax status net income and net worth A suitability statement signed by the registered representative indicating that the recommendations are in the best interests of the client A statement indicating the intended use of the annuity by the client Disclosures Disclosures to be made by the registered representative should include: the delivery of the appropriate prospectus, copies of illustration documents, and, where applicable, a receipt for the prospectus signed by the customer; information regarding the tax deferral status of the annuity and the fact that it would be redundant in a tax-qualified account such as an IRA; details of all sales and surrender charges; other fees charged against the account such as management fees, cost of insurance, mortality risk fees, and state or federal premium taxes; costs and effects of borrowing against the value of the policy; information regarding tax liabilities, both taxes and penalties in case of withdrawal before age 59½; death benefits provided in the contract and their tax consequences to beneficiaries; the process of review and approval of the contract, including contact that the firm will make during the review period; and information regarding the offer of a free-look period and the nature of the client s rights during this period Exchanges Title 26 Section 1035 of the IRS code refers to a provision that allows for the direct transfer of accumulated funds in a life insurance policy, endowment policy, or annuity policy to a "like" product (i.e. life insurance policy, endowment policy, or annuity policy) without creating a taxable event. For 1035 exchanges, the various states typically have extensive documentation

14 requirements for the exchange or replacement of annuity contracts. In complying with the requirements of Rule 2330, a broker/dealer firm will probably wish to create additional documentation for its internal compliance review and records. A suitability checklist to be completed by a registered representative and used by a supervisor in the analysis of exchange suitability would necessarily include: surrender charges still remaining on the contract to be replaced; a statement indicating whether the customer will be assuming a new surrender period and additional charges; whether the client will lose benefits provided by the annuity to be replaced; a statement regarding whether the client has exchanged a variable annuity in the last 36 months; and a statement, signed by the registered representative, indicating a reasonable basis for believing that the exchange is for the benefit and in the best interests of the client. Sales to Seniors Regulators, from the SEC to state securities Administrators, have increasingly shown grave concerns about sales of securities products particularly annuities to seniors and to individuals who are considering retirement in the near future. Past President of NASAA (North American Securities Administrators Association), Mr. Joe Borg, wrote a letter to the SEC expressing concern about the sales of variable and index annuities. His concerns were that unqualified and unregistered people were selling variable and index-linked annuities to seniors through aggressive and often unscrupulous tactics. My concerns with variable and equity index annuities are not about the products. These are legitimate and suitable investments for some, but they are unsuitable for many retirees. And yet they are being pitched aggressively to seniors through investment seminars, where participants aren t always told about high surrender charges for early withdrawals, the potential of exposure to market risk, and the steep sales commissions agents often earn when they move investors into these products. Supervisors of registered representatives who will include senior investors when prospecting for variable annuity clients have a particular obligation for more rigorous supervision over the activities of their registered representatives. Many senior citizens have limited investment experience but often a greater confidence in the

15 information given to them by individuals who describe themselves as investment professionals. Sales/Exchanges by New Representatives When a registered principal has a new registered representative to train, training must include the special responsibilities required to sell or exchange variable annuities. New to Firm New representatives include representatives who have previous industry experience but are new to the firm. Among the topics that should be included in a checklist for the training and supervision of the new representative are: training on the concept of annuities in general; additional training on the specifics of variable annuities, including costs and fees assessed; orientation on company-specific product enhancements and riders, including their costs; guidance on the ethical standards required by all levels of regulatory authority and local company expectations, including specifics about how the registered representative may describe himself to investors; and a reminder that information used in the sales/prospecting process with the public in most cases requires prior approval by a principal. For example, public seminar scripts must, in the majority of cases, be approved before use. This list is not comprehensive but represents some of the more serious concerns of the regulators regarding sales/exchanges involving variable annuities and senior investors. Indexed Annuity Update In January 2009, the SEC issued Rule 151A, which defined indexed annuities (IAs) as securities. However, before it was enacted, it was challenged by insurance companies and on legal grounds, Rule 151A was vacated. That means that for at least the foreseeable future, the SEC will drop its efforts to regulate this product. Because the court vacated Rule 151A, the SEC would have to completely start over. Fixed and Variable Characteristics They have characteristics of both fixed and variable annuities. In even more recent legislation, the Dodd-Frank act of 2010, specifically excludes indexed annuities from being called securities. Therefore, IAs currently are insurance products governed by state insurance regulations.

16 Indexed annuity sales have grown dramatically in recent years. Although the sales literature of at least one insurance company describes indexed annuities as simple, they are anything but easy to understand, particularly by potential investors. They offer a greater potential for growth than traditional fixed annuities but carry a higher risk. At the same time, IAs present a risk that is lower than the potential risk from variable annuities but also have a lower potential for return. An individual selling these products must understand them clearly to communicate the nature of the contracts to customers effectively. IAs offer what is known as a guaranteed minimum return in combination with an interest rate that is linked to one of the stock market indices, such as the S&P 500 Index. Because of the guaranteed interest rate, IAs have a lower market risk than traditional variable annuities, along with the potential for higher returns when the market is rising. The guaranteed minimum return from an IA is typically computed as 90% of premiums paid into the annuity at a 3% interest rate. This rate compares to a fixed annuity s guaranteed interest rate, except that the fixed annuity s rate is based on the total of premiums paid into the account. The index-linked portion of the contract is most frequently, as stated previously, linked to the movement of the S&P 500 Index. There are, however, other indices to which the annuity may be linked. Some insurance companies allow IA investors to select one or more indices. Computing Interest One of the more complex features of IAs is the method by which the indexlinked interest rate is calculated. The following are three of the more common methods of computing the interest rate gain: Please reference the online course to view this activity. It should be noted that some IA contracts allow for any of these fees to be changed at specified intervals such as the policy anniversary. If the contract allows these changes, this fact must be clearly communicated to the client. Additionally, the contracts use several different indexing methods to establish the change in the index relevant to the specific contract. Cursory descriptions of these methods are as follows. High water mark: This method credits interest on the basis of increases in the relevant index value at various points during the life of the contract, normally on contract anniversaries. The highest of these values is compared to the index level at the start of the contract and credits interest

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